(Photo by Flickr user visitBerlin, used under a Creative Commons license)
Raising capital is important for a high-growth-minded startup’s trajectory, but founders may find it difficult to differentiate between the various early-stage funding sources.
Priced rounds, for instance, allow a founder to gain clarity on their company’s worth and the division of ownership. But if a founder is looking for more flexibility, a convertible note or SAFE note could be the way to go.
Here’s an explainer on these three common modes of funding:
Priced equity rounds are the most traditional and original type of financing. These rounds are investments based on the company’s valuation, which is what the company is worth at the time of investment. After the founder and an investor agree on a valuation, the investor gives money in exchange for preferred stock in the company. The price per share is determined by the valuation. (Here’s some more useful info on valuations.)
Investors can also obtain more control rights — such as voting rights, anti-dilution rights and board member seats — in a priced round. Some investors serve as lead investors, meaning they can generate interest in the company to raise more capital. Having a lead investor may increase the amount of capital available to the founder, but the founder may have to reduce their control over the company.
Although priced equity rounds take longer to negotiate, priced equity rounds are advantageous in that they offer clear terms and certainty on dilution, but if a founder is looking to raise lots of capital, a priced equity round is a good option.
Convertible notes are an alternative form of investment. Essentially, convertible notes can convert into equity upon a future transaction, such as a priced equity round. Since convertible notes are debt instruments, they come with a maturity rate and interest rate.
Maturity dates are when the convertible note expires; if the note has not converted into equity by the maturity date, the company and investor have two options. The investor and founder can agree to extend the maturity date, or the founder must repay the investor’s investment with interest. Convertible notes also include valuation caps. Valuation caps set a maximum evaluation to determine the price per share; once valuation caps are reached, the investor’s money converts into equity.
Convertible notes are easy to execute, straightforward and highly customizable, and investors are enticed by the valuation cap’s protection on their investment. However, founders must be aware that convertible notes can dilute future rounds of funding; if a founder raises too much in convertibles, they can dilute their stock.
SAFE stands for Simple Agreement for Future Equity. SAFE notes are similar to convertible notes that convert into future stock, but they are considered a warrant, meaning they give investors certain equity rights. Since SAFE notes aren’t debt instruments, they do not have valuation caps. SAFE notes are better for founders who want to avoid maturity dates and interest rates. Like convertible notes, founders should be aware of the number of SAFE shares issued since they might risk diluting their shares.-30-
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